International Correlation Risk

Abstract

We document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative crosssectional relationship between average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia. All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means without the prior permission in writing of the publisher nor be issued to the public or circulated in any form other than that in which it is published. KeywordsRequests for permission to reproduce any article or part of the Working Paper should be sent to the editor at the above address. AbstractWe document that cross-sectional FX correlation disparity is countercyclical, as exchange rate pairs with high average correlation become more correlated in bad times whereas pairs with low average correlation become less correlated. We show that currencies that perform badly (well) during periods of high cross-sectional disparity in conditional FX correlation yield high (low) average excess returns, suggesting that correlation risk is priced in currency markets. Furthermore, we find a negative cross-sectional relationship between average FX correlations and average FX correlation risk premia. Finally, we propose a no-arbitrage model that can match salient properties of FX correlations and correlation risk premia.

The Share of Systematic Variation in Bilateral Exchange Rates

“…3 Following Verdelhan (2005, 2007), papers by DeSantis and Fornari (2008), Farhi et al (2009), Galsband and Nitschka (2010), Verdelhan (2010), Burnside, Eichenbaum, and Rebelo (2011), Christiansen, Ranaldo, and Soderlind (2011), Gilmore and Hayashi (2011), Hassan and Mano (2012), Menkhoff et al (2012aMenkhoff et al ( , 2012b, Mueller, Stathopoulos, and Vedolin (2012), Gavazzoni, Sambalaibat, and Telmer (2012), Jurek (2014), Lettau, Maggiori, and Weber (2014), Daniel, Hodrick, and Lu (2014), and Dobrynskaya (2014) study the properties of one-month interest rate-sorted portfolios of currency excess returns. Ang and Chen (2010), Hu, Pan, and Wang (2013), Kozak (2011) consider new sorts, focusing on properties of the foreign yield curves at longer horizons or on liquidity risk.…”

The Share of Systematic Variation in Bilateral Exchange Rates

“…3 Following Verdelhan (2005, 2007), papers by DeSantis and Fornari (2008), Farhi et al (2009), Galsband and Nitschka (2010), Verdelhan (2010), Burnside, Eichenbaum, andRebelo (2011), Christiansen, Ranaldo, andSoderlind (2011), Gilmore and Hayashi (2011), Hassan and Mano (2012), Menkhoff et al (2012aMenkhoff et al ( , 2012b, Mueller, Stathopoulos, and Vedolin (2012), Gavazzoni, Sambalaibat, and Telmer (2012), Jurek (2014), Lettau, Maggiori, and Weber (2014), Daniel, Hodrick, and Lu (2014), and Dobrynskaya (2014) study the properties of one-month interest rate-sorted portfolios of currency excess returns. Ang and Chen (2010), Hu, Pan, and Wang (2013), Kozak (2011) consider new sorts, focusing on properties of the foreign yield curves at longer horizons or on liquidity risk.…”

Global Political Risk and Currency Momentum

“…We find that currency excess returns are larger in high-political-risk portfolios than in low-political-risk portfolios under low-or high-IV portfolios, implying a statistically significant and positive spread. We perform similar exercises by replacing IV with illiquidity, volatility, and a correlation variable (e.g., Mueller, Stathopoulos, and Vedolin (2013)) and reach the same conclusion. These results provide further support for the pricing ability of global political risk for currency momentum.…”